Changes in the Venture Capital Funding Environment
The funding environment for tech startups is an ever shifting ground as we go through predictable shifts that go hand-in-hand with the slowing of the overall market.
The most important shift I would characterize as the market moving from “high conviction” and thus strong follow-ons to “limited conviction” and lots of gamesmanship / games of chicken … at your expense.
Here is a brief history first to put the changes into context.
- Rise of Seed. To understand today’s trend it’s worth stepping back a decade or so. Prior to then the concept of “seed funds” barely existed and as I’ve argued before the seed fund phenomenon was largely driven by: Open source + horizontal computing + Amazon AWS. In other words, it isn’t that VCs suddenly got smart, it’s that the costs of starting a company went down dramatically.
- Rise of Angels. The second major trend was the rise of the angel that was a function of the boom in Silicon Valley wealth (Google, Facebook, Zynga, Twitter, Salesforce.com, etc) plus the rise of crowd-funding platforms (AngelList) plus the rise of Y Combinator / 500Startups / TechStars.
- Boom in Number of Startups. There was an explosion in number of startups both because it was cheap and there was tons of available capital.
- Explosion in Seed Funds. I remember when seed funds first started (they were being incorrectly called “super angels” and then Micro VCs before Seed Funds stuck) and every LP (who invest in VCs) told me they weren’t convinced about Seed Funds (too small, too hard to pick winners, would they be able to follow on?). Now seed funding is conventional wisdom. I
- Leaderless Rounds. With a massive increase in companies created and a huge number of sources one trend that we witnessed from 2012–2015 was the rise of the undisciplined round. Specifically I mean teams that were going too fast at raising, optimizing around the highest price or avoiding larger investors because they wanted a lot of small players who couldn’t exert any control (terms, price, etc.). This works in a booming market or in a company that never hits any headwinds.
- Non VC Growth Rounds. The other major trend of 2012–2015 was the entrance of “non VCs” into late-stages of venture capital, which mostly consisted of hedge funds, mutual funds, corporate investors, sovereign wealth funds and even LPs doing direct deals. This led median valuations to triple in 3 years and led to this stupid phenomenon that people refer to as “unicorns,” which I am convinced will the the thing most historians laugh most about in this era. The fact that I still see it referred to in pitch decks is farcical.
- Late-Stage VCs Pay Up. VCs of course responded to all of this by raising larger funds, raising growth funds and making sure they didn’t miss out on marquee deals — even if it meant investing when a company was already worth billions of dollars (otherwise not known as venture capital). Some called this “buying logos.”
- The market eventually slowed down. In Q3/Q4 2015 the market changed noticeably for VC funds and the market started to realize this by Q1 2016. While a slowdown is hard to pinpoint to a single event, I’d say the most telling “Black Swan” event was the day that LinkedIn and Tableau lost 50% of their public market caps in a single day. It had come on the heels of a long, public slide at Twitter and the beginning of a questioning about valuations overall.
Where does that leave us now?
There is a lot of resetting that has already taken place. I have spoken about some of it here in my quick video primer I called “clash of the titans” and you can get some more broad-based fund-raising environment commentary on my snapstorms/fundraising page, which I’ll continue to update.
But there are two major trends worth understanding that most VCs know by now and I suspect most entrepreneurs do not. That is simply because we see 20–25 deals / year across our funds (new and follow-ons) and entrepreneurs usually see 1 deal every 2 years.
- VC Infighting. In a booming market everybody felt like each stage of investors’ interests were aligned. In fact, sometimes they were synergistic. Angels / seed often wanted to exit early and late-stage wanted more ownership than founders would sell so secondary transactions were common. But now the trend is in-fighting. If a company raised a big B and/or C round and needs more money the late stage guys have the bucks and that early-stage guys often don’t. So in companies with high burn rates you can find the following: Seed funds wanting to sell the company / get a return or growth investors pushing for a recap or massive down round. I’ve seen this a bunch in the past 12 months. These are extreme positions and often the deals settle in between but it can be U-G-L-Y and the financings are at times coupled with changing management teams.
- Lack of Conviction / Follow Through. In a booming market the trend was that everybody was fighting to take their full prorata shares. In fact, many seed funds set up “opportunity funds” or “overage funds” so they could follow longer. But with inside rounds (where there is no outside lead) more common these days the most worrying trend I see is the lack of support exiting investors are showing. If you have 2–3 traditional VC funds they usually work together in tough times. There are unwritten rules in The Valley — you don’t screw other investors when everybody decided to pitch in and help out the company. It is a norm that is held because it’s a multi-party game (Prisoner’s Dilemma) in which you want to work with these funds again. It helps control bad instincts / behavior. But with so many newer seed funds in deals, with so many VC funds created in the last 5–7 years (never managed through a non-booming market) and so many non-VCs around — these norms aren’t holding.
- There was an A-prime round of a high-profile deal coming together. 3VCs agreed to fund an inside round and cut costs. But at the last minute one got cold feet after looking more closely at the data. They were the smallest of the three shareholders in ownership but the largest fund. They pulled out. The other two didn’t want to shoulder the burden. Fighting broke out, time was running out … and the company went bankrupt. Expect more of this.
- There was a C-round deal where the company ran out of money unexpectedly. The largest fund saw this as an opportunity to drive down price since they felt they overpaid in the last round. Early investors fought. It dragged for months but a deal got done. People lost jobs.
- A company that had an offer to be acquired but needed time to complete the M&A process. Some funds came in — one literally said “we have no more reserves” and ended up funding a trivial amount. The committed funds bit their lips because the company was going to miss payroll and just funded it anyway to preserve the peace.
- A company with strong prospects but needed a bridge round to get to a fund raising event. One lead fund agreed to do prorata, 2 other funds decided they’d prefer to do “half of their prorata.” This lack of support is now commonplace and is a warning sign to those who believe that: leaderless round or “dumb money, highly priced” are good ideas. There are good VCs and bad VCs and I don’t want to pretend otherwise. But in this industry you are way more likely to see consistent actions from those who understand the rules of the game vs. new entrants who can be fair-weather friends.
The industry is changing in predictable ways. Be thoughtful about from whom you raise capital. Always assume that if you’re able to raise money in good markets but will have to also raise in tougher markets. Think through your strategy when money is easy and ask yourself how these funding sources will act in a tough market.
For year’s I have counselled to “raise at the top end of normal” and in my seminal “lines, not dots” post I’ve pointed out many times in public speeches that if VCs need to get to know you above time (a line) then you need to know your investors even more so. VCs can afford to get a few decisions wrong. One wrong decision by an entrepreneur can torpedo all of your hard work or your future.
(Cross-posted @ Both Sides of the Table)